1 Bank Market Power and Liquidity Creation Hana Bawazir a,b,1 Marta Degl’innocenti a Simon Wolfe a a Southampton Business School, University of Southampton, UK. b Collage of Business Administration, University of Bahrain, Bahrain. Abstract We empirically investigate how bank market power affects liquidity creation for a large sample of banks in the euro area countries from 2006-2015. Using the instrumental variables approach to deal with possible endogeneity concerns, we find market power as measured by Lerner indices increases liquidity creation significantly. We shed further light on the market power and liquidity creation nexus by examining the interaction effect of market power and regulatory intervention during the global financial crisis. We find that government intervention only affects banks with low market power. Additional results include the effects of market power on various components of liquidity creation as well as bank profitability. Our main results remain robust to several robustness checks. JEL classification: G21, G28, L16 Keywords: Liquidity creation, Basel III, Bank market power 1 Corresponding Author. Email address: [email protected], [email protected] (Hana Bawazir), [email protected](Marta Degl’innocenti), [email protected] (Simon Wolfe)
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1
Bank Market Power and Liquidity Creation
Hana Bawazira,b,1 Marta Degl’innocenti a Simon Wolfe a
a Southampton Business School, University of Southampton, UK. b Collage of Business Administration, University of Bahrain, Bahrain.
Abstract
We empirically investigate how bank market power affects liquidity creation for a large sample of
banks in the euro area countries from 2006-2015. Using the instrumental variables approach to
deal with possible endogeneity concerns, we find market power as measured by Lerner indices
increases liquidity creation significantly. We shed further light on the market power and liquidity
creation nexus by examining the interaction effect of market power and regulatory intervention
during the global financial crisis. We find that government intervention only affects banks with
low market power. Additional results include the effects of market power on various components
of liquidity creation as well as bank profitability. Our main results remain robust to several
robustness checks.
JEL classification: G21, G28, L16
Keywords: Liquidity creation, Basel III, Bank market power
Our first liquidity creation proxy is based on the regulatory standards proposed by the
Basel Committee on Banking Supervision (BCBS, 2010). Following the global financial crisis and
in recognition of the need for banks to improve their liquidity management, the Basel Committee
on Banking Supervision developed an international framework for liquidity assessment in banking.
Among the several guidelines, the Basel III accords include the implementation of a net stable
funding ratio (NSFR). This ratio aims to promote resiliency over long-term time horizons by
creating additional incentives for banks to fund their activities with more stable sources of funding.
2 Six countries are removed from our sample as banks in these countries fail to meet our selection criteria. These countries include Estonia, Finland, Lithuania, Poland, Romania and Slovenia.
10
This liquidity measure is the ratio of the available amount of stable funding to the required amount
of stable funding.
We are among the first studies that use the inverse net stable funding ratio (I.NSFR) as a
proxy of liquidity creation (Distinguin et al., 2013; Casu et al., 2016). Hence, we calculate our
liquidity creation indicator as the amount of required stable funding (RSF) relative to the amount
of available stable funding (ASF) (BCBS, 2010).
𝐼. 𝑁𝑆𝐹𝑅𝑖𝑡 =𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑆𝑡𝑎𝑏𝑙𝑒 𝐹𝑢𝑛𝑑𝑖𝑛𝑔𝑖𝑡
𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑆𝑡𝑎𝑏𝑙𝑒 𝐹𝑢𝑛𝑑𝑖𝑛𝑔𝑖𝑡 (4)
Required Stable Funding (RSF) is a weighted sum of the uses of funding sources (assets
and off-balance sheet) according to their liquidity. While Available Stable Funding (ASF) is a
weighted sum of funding sources according to their stability features. Appendix A shows the
breakdown of a bank balance sheet as provided by BankScope and its weighting with respect to
the Basel III framework to calculate the inverse of the net stable funding ratio. We follow the same
assumptions made by Distinguin et al. (2013) and Gobat et al. (2014) to compute NSFR.
In addition, we calculate four measures of liquidity creations following Berger and
Bouwman (2009) and Berger et al. (2016) using a three-step procedure. In step 1, we classify all
bank balance sheet and off-balance sheet activities using information on the category and maturity
of banks’ assets and liabilities as liquid, semi-liquid, or illiquid. This is done based on the ease, cost,
and time it takes customers to obtain liquid funds from the bank (liability-side of a balance sheet),
and based on the ease, cost and time with which banks can dispose their obligations in the case of
asset items (asset-side of a balance sheet). In step 2, we assign weights of either +1/2, 0, or -1/2
to the activities classified in step 1. The weights correspond to liquidity creation theory. According
to this theory, banks create liquidity by converting illiquid assets into liquid liabilities. In contrast,
banks destroy liquidity by transforming liquid assets into illiquid liabilities or equity (see Berger
and Bouwman, 2009). In step 3, we combine the activities as classified in step 1 and as weighted
in step 2 in different ways to construct our liquidity creation measures. Total liquidity creation
(TLC) for each bank considers both on- and off- balance sheet activities. Instead of using TLC,
we also use an (off-balance sheet) measure where we only include off-balance sheet activities. Similarly,
we decompose the TLC measure and construct two proxies (asset-side and liability-side) that focuses
on on-balance sheet activities. Appendix B provides a classification of bank activities and
construction of four liquidity creation measures.
Higher values of all measures will indicate higher illiquidity. Higher levels of liquidity
creation mean that banks invest more liquid liabilities in illiquid assets. In this context, a bank faces
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risk if some liquid liabilities invested in illiquid assets are claimed on demand. We run the
regressions in changes rather than levels because this allows us to observe how changes in our
explanatory variables lead to changes in liquidity creation at one particular bank in the following
year and avoids our results being driven by cross-sectional variation in the data (see Berger et al.
(2010) and Berger et al. (2016)).
4.3 Explanatory Variables: Market Power Measures
We examine the impact of market structure in banking on liquidity creation using two
Lerner indices as indicators of the degree of market power and clarify which one is our preferred
measure. First, the traditional Lerner index that assumes fully efficient banks represents the mark-
up of price over marginal costs. Following the banking literature (Amidu and Wolfe (2013a),
Fungáčová et al. (2014) and Berger and Roman (2015)), the traditional Lerner index is calculated
at the bank level as:
𝐿𝑒𝑟𝑛𝑒𝑟𝑗𝑡 =𝑃𝑗𝑡−𝑀𝐶𝑗𝑡
𝑃𝑗𝑡 (5)
Where 𝑃𝑗𝑡 is the price of bank output which is calculated as the ratio of total income over
total assets for bank 𝑗 at time 𝑡, and 𝑀𝐶𝑗𝑡 is the marginal cost of the production of that output for
bank 𝑗 at time 𝑡. When the marginal cost is not available as in most empirical data sets, it can be
estimated using econometric methods. We use a popular approach through estimating a translog
cost function and take its derivative to obtain the marginal cost. We follow Koetter et al. (2012)
and employ the following translog cost function as:
with the revised Basel III NSFR. Similarly, on the liability side, the differences are in the factor
given to stable deposits, we increase the weight from 70% to 95% and decrease less stable from
100% to 90%. Whereas unsecured wholesale funding increased form 0% to 50%.
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Insert Table 11
7. Conclusion
This paper examines the impact of bank market power on liquidity creation for a large
sample of banks in the euro area countries from 2006 to 2015. Using an instrumental variable
approach, we find market power as measured by Lerner indices increases liquidity creation
significantly. Further investigation suggests that market power affects liquidity creation on the
asset-side and the liability side of the balance sheet, but it does not affect liquidity creation off the
balance sheet. We compute adjusted Lerner index where we explicitly compare it with the
traditional Lerner index. We find that it is important to adjust for profit inefficiency as calculating
market power using traditional Lerner overestimate bank profitability by more than 50%. Overall,
our results show that Lerner indices have a positive impact on bank profitability.
As a further step, we investigate how regulatory interventions during the global financial
crisis affect liquidity creation. We find a negative relationship between the combined effect of
market power and guarantees and liquidity creation, while it is positive for the combined effect of
market power and recapitalisation for the (TLC) only. Our main results remain robust to several
robustness tests.
The results also suggest several policy implications. First, bank market power matters for
macroprudential policies. We find evidence that banks take on more liquidity risk as they achieve
greater market power. As market power can have detrimental economic effects through its impact
on liquidity creation. The ECB should monitor the structure of the banking sector not only for
financial stability reasons, but also to encourage liquidity creation as it may lead to higher levels of
economic growth. However, in light of the recent liquidity rules, as banks are required to hold
more liquid assets. Thus, policymakers facing conflicting objectives between sustainable economic
growth through liquidity creation and effectiveness of Basel III policy.
Second, we find higher required capital ratios may discourage liquidity creation within
banks. Hence, the implementation of Basel III may result in reduced liquidity creation by
introducing tightened capital requirements, therefore, slowing economic growth through a
reduction in the amount available for financing. Therefore, it is necessary to look for a trade-off
between benefits for a financial system from stronger capital and liquidity regulations and benefits
of greater liquidity creation.
Furthermore, given the differences between liquidity creation measures based on Berger
and Bouwman (2009) and Basel III BCBS (2010), using the (I.NSFR) measure for liquidity creation
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may be useful to add to the debate on liquidity assessment in banking. This level of liquidity
creation could be considered to appreciate the ability of banks to face transformation risk when
they create liquidity. However, given the ambiguity in the definition and measurement of liquidity
under a global regulatory framework, it is recommended that regulators further clarify what type
of liquid liabilities should be considered stable. By better understanding what factors significantly
impact bank exposure to transformation risk, it can help banks to improve their risk management
framework.
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Table 1: Composition of sample observations by country and bank type
Notes: This table presents a description of all observations included in the sample by country and bank type. Source: BankScope & authors’ calculations.
Country Total Commercial Banks Savings Banks Cooperative Banks
Total number of banks
15,761 2,078 3,994 9,689
percent of sample 100% 14% 25% 61%
of which Observations by category
1 Austria (AT) 709 113 379 217
2 Belgium (BE) 72 66 3 3
3 Bulgaria (BG) 10 10 0 0
4 Cyprus (CY) 6 6 0 0
5 Czech Republic (CZ) 89 70 0 19
6 Germany (DE) 9,449 317 3,109 6,023
7 Denmark (DK) 242 143 80 90
8 Spain (ES) 38 22 11 5
9 France (FR) 1,065 406 137 522 10 United Kingdom (UK) 222 221 0 1
11 Greece (GR) 1 1 0 0
12 Croatia (HR) 7 7 0 0
13 Hungary (HU) 2 2 0 0
14 Ireland (IE) 1 1 0 0
15 Italy (IT) 3,444 384 207 2,853
16 Luxembourg (LU) 124 111 3 10
17 Latvia (LV) 47 47 0 0
18 Malta (MT) 17 17 0 0
19 Netherlands (NL) 88 78 0 0
20 Portugal (PT) 88 35 46 7
21 Sweden (SE) 33 15 18 0
22 Slovakia (SK) 7 6 1 0
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Table 2: Summary Statistics
N Mean SD Min Max
Dependent Variables
INSFR 15,761 1.27 0 .84 0 .001 32.79
TLC 15,761 0.21 0.21 -0.98 6.64
LC off-balance sheet 15,761 0.02 0.09 -0.009 6.63
LC asset-side 15,761 0.04 0 .21 - 0.78 0.53
LC liability-side 15,761 0.18 0.16 -0.91 0.59
Main Explanatory Variables
Traditional Lerner index 15,761 0.05 0.34 -6.62 0.92
Adjusted Lerner index 15,761 0.09 0.47 -12.93 0.91
Variables used in the derivation of market power
Interest income * 15,761 86.16 1315.74 0.01 124074.6
Non-interest income * 15,761 47.75 627.28 0.001 51261.18
Securities* 15,761 1967.31 27163.79 0.001 1534152
Loans* 15,761 3068.88 36556.21 0.15 2974721
Price of physical capital 15,761 1.31 2.65 0.22 26.41
Price of labour 15,761 0.01 0.003 0.002 0.02
Price of borrowed funds 15,761 0.02 0.01 0.002 0.07
Marginal cost (OLS) 15,761 0.02 0.008 0.0007 0.19
Marginal cost (SFA) 15,761 0.03 .0084 0.0007 0.19
Instruments
Financial freedom 15,761 61.91 8.21 50 90
Banking activities 15,761 1.61 0.49 1.3 2.5
Entry restrictions 15,761 6.65 0.93 1 8
Control Variables
Total Assets* 15,761 6063.024 72551.92 0.35 5240319
Capital 15,761 2.04 3.07 0.0004 83.64
ROE 15,761 4.87 5.50 -193.54 89.12
LLP 13,636 5.16 0.94 -11.85 -1.38
NII 15,542 1.14 0.95 -6.16 6.03
Commercial 15,761 0.13 0.33 0 1
Savings 15,761 0 .25 0.43 0 1
Crisis dummy 15,761 0.21 0.41 0 1
Notes: This table reports summary statistics on selected variables used throughout the paper from 2006-2015. It contains the means, standard deviations, minimum and maximum values for each variable. * All values are in millions of dollars. Source: BankScope database and the Heritage Foundation.
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Table 3: Adjusted and Unadjusted Lerner Indices: EU Banks in the period 2006-2015
Notes: This table presents the difference between unadjusted and adjusted Lerner indices as well as the mean per year of our liquidity creation measures indicated by INSFR and TLC.
Table 4: Correlation Matrix for all Independent variables
Notes: This table presents the correlation matrix for our independent variables. * Implies significance at 5% or more.
Source:
BankScope database.
Lerner Index Spearman's Rank Correlation Liquidity Creation
Notes: Panel A: reports the first stage regressions in columns 1 and 2 as well as the results from instrumental variable regressions. The dependent variables are measures of liquidity creation. Inverse net stable funding ratio (∆I.NSFR) in columns 3 and 5, total liquidity creation (∆TLC) in columns 4 and 6. Robust standard errors are reported in parentheses. Country and time-specific effects included but not reported. Panel B: reports specification tests for validity of instruments. The null hypothesis of the robust Wooldrige overidentification score test is that instruments are valid. The null hypothesis for the exogeneity test is that the instrument variable is not endogenous. F statistic report the explanatory power of the regressions. Significance at *10%, **5%, ***1%. Data source: BankScope database. Coverage: 2006-2015.
30
Table 6: IV Regression Results of the Impact of Bank Market Power on Components of Liquidity Creation
Notes: Panel A: reports the results from instrumental variable regressions. The dependent variables are measures of components of liquidity creation. Asset-side liquidity creation (∆LC asset-side) in columns 1 and 4, liability-side liquidity creation (∆LC liability-side) in columns 2 and 5, and off-balance sheet liquidity creation (∆LC off-balance sheet) in columns 3 and 6. Robust standard errors are reported in parentheses. Country and time-specific effects included but not reported. Panel B: reports specification tests for validity of instruments. The instruments
used are 1) financial freedom provides overall measures of the openness of the banking sector. 2) Bank activity restrictions and 3) Entry restrictions. The null hypothesis of the robust Wooldrige overidentification score test is that instruments are valid. The null hypothesis for the exogeneity test is that the instrument variable is not endogenous. F statistic report the explanatory power of the regressions. Significance at *10%, **5%, ***1%. Data source: BankScope database. Coverage: 2006-2015.
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Table 7: IV Regression Results of the Impact of Bank Market Power on Bank Profitability
Notes: Panel A: reports the results from instrumental variable regressions. The dependent variables are measures of bank profitability. Return on assets (∆ROA) in columns 1 and 4, return on equity (∆ROE) in columns 2 and 5, and net interest margin (∆NIM) in columns 3 and 6. Robust standard errors are reported in parentheses. Country and time-specific effects included but not reported. Panel B: reports specification tests for validity of instruments. The instruments used are 1) financial freedom provides overall measures of the openness of the banking sector. 2) Bank
activity restrictions and 3) Entry restrictions. The null hypothesis of the robust Wooldrige overidentification score test is that instruments are valid. The null hypothesis for the exogeneity test is that the instrument variable is not endogenous. F statistic report the explanatory power of the regressions. Significance at *10%, **5%, ***1%. Data source: BankScope database. Coverage: 2006-2015.
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Table 8: Pooled ordinary least squares regression during crisis period: from 2008-2011
Notes: This table reports the results of a pooled ordinary least squares regression with robust standard errors clustered at the bank level. We control for country and year fixed effect. Bank controls include size, capital, ROE, LLP, Commercial, Savings and crisis dummy. Notice that the total number of observations (4628) reflects the unbalanced nature of the dataset. Significance at *10%, **5%, ***1%. Data source: BankScope database. Coverage: 2008-2011.
Notes: this table presents the results of vaious robustness tests. Columns 1 and 2 present the results for bank market power and bank specialization. Columns 3 and 4 present the results for bank market power and capital. Columns 5 and 6 presnt the result for bank market power and small size banks. Finally, columns 7 and 8 presents the results including macroeconomic control variables. Significance at *10%, **5%, ***1%. Data source: BankScope database. Coverage: 2006-2015.
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Table 10: Robustness Checks- Clustering Standard Errors by Bank and Year
Notes: this table presents the results of a further robustness check of using alternative measure of liquidity creation applying Basel III more recent October 2014 factors to calculate the INSFR in columns 5 and 6. Robust standard errors are reported in parentheses. Country and time-specific effects included but not reported. Panel B: reports specification tests for validity of instruments. The instruments used are 1) financial freedom provides overall measures of the openness of the banking sector. 2) Bank activity restrictions and 3) Entry restrictions. The null hypothesis of the robust Wooldrige overidentification score test is that instruments are valid. The null hypothesis for the exogeneity test is that the instrument variable is not endogenous. F statistic report the explanatory power of the regressions. Significance at *10%, **5%, ***1%. Data source: BankScope database. Coverage: 2006-2015.
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Appendix A: Variable Definitions and Sources Name Description Data Source
A. Measures of Market Power Cost of fixed assets sum of general administrative expenses, depreciation, amortisation, occupancy costs, software costs, operating
lease rentals and other operating expenses, divided by fixed assets BankScope database
Cost of labour personnel expenses divided by total assets BankScope database Cost of borrowed funds total interest expenses divided by total deposits, money markets and short-term funding BankScope database Total securities Sum of reverse repos and cash collateral, trading securities and FV through income, derivatives, AFS securities,
HTM securities, at-equity investments in associates and other securities. BankScope database
Total loans Sum of residential mortgage loans, other mortgage loans, other consumer/retail loans, corporate and commercial loans and other loans.
BankScope database
Equity total common equity BankScope database Operating costs sum of total interest expenses, loan impairment charge, other operating expenses and personnel expenses BankScope database Profit before tax Pre-tax profit BankScope database B. Measures of Liquidity Creation I.NSFR Required Stable Funding divided by Available Stable Funding (Basel III) BankScope database TLC/ Total assets measure of liquidity creation based on Berger et al., 2016 BankScope database LC off-balance sheet / Total assets measure of liquidity creation based on Berger et al., 2016 BankScope database LC asset side/ Total assets measure of liquidity creation based on Berger et al., 2016 BankScope database LC liability side/ Total assets measure of liquidity creation based on Berger et al., 2016 BankScope database C. Bank characteristics
Size Total assets in logarithmic form. BankScope database Capital Total equity to total assets BankScope database LLP Loan loss provisions divided by total loans BankScope database ROE Return on equity (%) BankScope database Crisis dummy Dummy variable. It takes value 1 for the years 2008 and 2009 and 0 otherwise. BankScope database Commercial Dummy variable. It takes value 1 for commercial banks and 0 otherwise. BankScope database Savings Dummy variable. It takes value 1 for savings banks and 0 otherwise. BankScope database Cooperatives Dummy variable. It takes value 1 for Cooperative banks and 0 otherwise. BankScope database D. Country- level variables
GDP Growth Rate of growth of the Gross Domestic Product (real) World Bank Inflation rate of consumer price index World Bank E. Instrumental variables
Banking activity restrictions the degree to which national regulatory authorities allow banks to engage in the following three fee-based rather than more traditional interest-spread-based activities: Securities activities, insurance activities and real estate activities
Barth et al. (2001) and Barth et al. (2004)
Entry restrictions The specific legal requirements for obtaining a license to operate as a bank. This variable takes on values between (1) and (8), where higher values indicate lower entry restrictions.
Barth et al. (2001) and Barth et al. (2004)
Banking freedom An indicator for the openness of a banking system. The index offers data on whether foreign banks are allowed to operate freely, on difficulties faced when establishing banks, and on government influence over credit allocation. The index ranges from 0 to 100 percent, where higher values indicate fewer restrictions.
Heritage foundation.
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Appendix B: Classification of bank activities as documented in the Basel III report and construction of I.NSFR as a liquidity creation measure from
BankScope and associated ASF and RSF.
Basel Proposal BankScope Item Structure (Used in NSFR Calculations)
Factors following Distinguin et al. (2013)
Available Stable Funding (ASF)
Equity & Liabilities
Total regulatory Capital Shareholders' Equity 1.00
Secured and unsecured borrowings and liabilities > 1 year Total long-term funding 1.00
Senior debt maturing after 1 year 1.00
Subordinated borrowing 1.00
Other funding 1.00
Stable deposits < 1 year Customer deposits- Savings 0.7
Customer deposits- Term 1.00
Less stable deposits < 1 year Customer deposits-Current 0.7
Required Stable Funding (RSF) Assets cash immediately available to meet obligations Cash and due from banks 0
loans to financial entities < 1 year Loans and advances to banks 0
Marketable securities ≥ 1 year representing claims on sovereigns, Central Banks, BIS, IMF, Marketable securities and other short-term investments 0
EC, non-central government PSEs
loans to non-financial corporate clients < 1 year Corporate and commercial loans 1
loans to retail < 1 year Other consumer/ Retail loans 1
loans to non-financial corporate clients > 1 year Corporate and commercial loans 0.65
loans to retail > 1 year Other consumer/ Retail loans 0.85
Residential mortgages of any maturity Residential mortgage loans 0.65
other mortgage loans 0.65
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Appendix B (Continued )
Basel Proposal BankScope Item Structure (Used in NSFR Calculations) Factor October 2014
Other performing loans with risk weights greater than 35% under the Standardised Approach and residual maturities of one year or more Other loans 0.85
equity securities not issued by financial institutions
All other assets not included in the above categories Other earning assets 1.00
Total assets - total earning assets 1.00
Investment in property 1.00
Fixed assets 1.00
Insurance assets 1.00
Other assets 1.00
Off-Balance Sheet Items
Irrevocable and conditionally revocable credit and liquidity facilities to any client Managed Securitized assets reported off-balance sheet 0.05
Other off-balance sheet exposure to securitizations 0.05
Notess: Source: Basel III, BankScope and authors’ calculation.
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Appendix C: Classification of bank activities and construction of five liquidity creation measures
Step 1: Classify all bank activities as liquid, semi-liquid, or illiquid based on product category "Cat" and maturity "Mat" Step 2: Assign weights to the items classified in Step 1.
Corporate and commercial loans Residential mortgage loans Cash and due from banks other loans Other mortgage loans Trading securities and at future
value through income Investments in property Other consumer/retail loans Derivatives Insurance assets Loans and advances to banks Available for sale securities Fixed assets Held to maturity securities At-equity investments in
associates Other securities
LIABILITIES PLUS EQUITY
Liquid liabilities(weight= 1/2) Semi-liquid liabilities (weight=0) Illiquid liabilities plus equity (weight= -1/2) Customer deposits-Current Customer deposits-Term Senior debt maturing after 1 year
Customer deposits-Savings Deposits from banks Subordinated borrowing Repos and cash collateral Other funding Other deposits and short-term borrowing Other liabilities Fair value portion of debt Total Equity
Notes: We follow Berger and Bouwman (2009), Molyneux et al. (2016) and Berger et al. (2016) to classify the on- and off- balance sheet items. Source: BankScope database.